European Financial Regulation

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <div align="left"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">European Financial Regulation</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <a href="#CAD II">CAD II</a><p class="word_list"> <a href="#CAD III">CAD III</a><p class="word_list"> <a href="#Capital Adequacy Directive">Capital Adequacy Directive (CAD)</a><p class="word_list"> <a href="#Investment Services Directive">Investment Services Directive</a><p class="word_list"> <a href="#Own Funds Directive">Own Funds Directive</a><p class="word_list"> <a href="#Second Banking Coordination Directive">Second Banking Coordination Directive</a><p class="word_list"> <a href="#Securities firms">securities firm</a><p class="word_list"> <a href="#Solvency Ratio Directive">Solvency Ratio Directive</a><p class="word_list"> <a href="#universal banking">universal bank</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" style="border-collapse: collapse" bordercolor="#111111" width="310" align="right" id="table5"> <tr> <td align="right" width="9" height="14"></td> <td width="300" height="14"> <font size="2"> </font><font size="4"> </font></td> </tr> <tr> <td align="right" width="9"> </td> <td width="300"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> </tr> </table> <p>Until the 1980s, the United Kingdom enforced no statutory separation of banking and securities industries, but distinguished between them as a matter of custom. The Bank of England supervised banks. <b> <a name="Securities firms">Securities firms</a></b>—firms that broker or deal in <a href="../articles/security.htm">securities</a>—were traditionally self-regulating. The 1986 Financial Services Act changed this, establishing separate regularity functions for banks and securities firms.</p> <p>Germany had a tradition of <b><a name="universal banking">universal banking</a></b>, which made no distinction between banks and securities firms. Under German law, securities firms were banks, and a single regulatory authority oversaw banks. France and the Scandinavian countries had similar regimes. Accordingly, Europe supported two alternative models for financial regulation: </p> <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10">the Continental, or German model of universal banking, and <p class="bullet_line_space"><img border="0" src="../images/bullet.gif" width="20" height="10">the Anglo-Saxon or British model of separate banking and securities activities. <p>The European Union (EU) had a goal of implementing a common market by 1993. As the nations of Europe moved towards integrating their economies, the two models of financial regulation came into conflict. New EU laws needed either to choose between or somehow blend the two approaches. </p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="345" align="left" id="table6"> <tr> <td width="336" height="10"><font size="2"> </font></td> <td width="9" height="10"></td> </tr> <tr> <td width="336"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script>  </td> <td width="9"> </td> </tr> </table> <p>The issue was settled by the 1989 <b> <a name="Second Banking Coordination Directive">Second Banking Coordination Directive</a></b> and the 1993 <b><a name="Investment Services Directive">Investment Services Directive</a></b>. These granted European nations broad latitude in establishing their own legal and regulatory framework for financial services. Financial firms were granted a “single passport” to operate throughout the EU subject to the regulations of their home country. A bank domiciled in an EU country that permitted universal banking could conduct universal banking in another EU country that prohibited it. With France and Germany committed to universal banking, the single passport model effectively opened all of Europe to universal banking. It also permitted Britain to maintain a separate regulatory framework for its non-bank securities firms. </p> <p>Since the securities operations of Germany’s universal banks would be competing with Britain’s non-bank securities firms, there was a desire to <a href="../articles/regulatory_capital.htm">harmonize</a> <a href="../articles/capital_allocation.htm">capital</a> requirements for the two. The solution implemented with the 1993 <b><a name="Capital Adequacy Directive">Capital Adequacy Directive</a></b> (CAD) was to regulate functions instead of institutions. </p> <p>The CAD established uniform capital requirements applicable to both universal banks’ securities operations and non-bank securities firms. A universal bank would identify a portion of its balance sheet as comprising a “trading book.” Capital for the trading book would be held in accordance with the CAD while capital for the remainder of the bank’s balance sheet would be held in accordance with the 1988 Basel Accord, as implemented by Europe’s 1989 <b><a name="Solvency Ratio Directive">Solvency Ratio Directive</a></b>. Bank capital was conservatively defined according to the 1989 <b><a name="Own Funds Directive">Own Funds Directive</a></b>, but local regulators had discretion to apply more liberal rules for capital supporting the trading book. </p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="165" align="right" id="table7"> <tr> <td width="11"> </td> <td width="160"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script> </td> </tr> </table> <p>A bank’s trading book would include equities and fixed income securities held for dealing or proprietary trading. It would also include <a href="../articles/common_stock.htm">equity</a> and fixed income <a href="../articles/exchange_traded.htm">OTC</a> <a href="../articles/derivative_instrument.htm">derivatives</a>, <a href="../articles/repo.htm">repos</a>, certain forms of <a href="../articles/securities_lending.htm">securities lending</a> and exposures due to <a href="../articles/settlement.htm">unsettled</a> transactions. Foreign exchange exposures were not included in the trading book but were addressed organization-wide under a separate provision of the CAD. </p> <p>A minimum capital requirement for the <a href="../articles/market_risk.htm">market risk</a> of a trading book was based upon a crude <a href="../articles/value_at_risk.htm">value-at-risk</a> (VaR) measure intended to loosely reflect a 10-day 95% <a href="../articles/var_metric.htm">VaR metric</a>. This entailed separate “general risk” and “specific risk” computations, with the results summed. The measure has come to be known as the “building-block” approach. </p> <p>Europe developed the CAD at the same time that the <a href="../articles/basle_committee.htm">Basel Committee</a> was developing an amendment covering market risk for its 1988 capital accord. The two initiatives influenced each other. Essentially, Europe was pursuing locally what Basel was pursuing globally. European regulators had hoped that both initiatives could be completed simultaneously, but this was not to be. The EU had set a deadline of 1992 for reaching agreement on all significant single-market legislation. The Basel Committee's work continued until 1996. Accordingly, the CAD was passed three years before the 1996 amendment to the Basel Accord was complete. </p> <p style="margin-bottom: 24">In 1993, the CAD and proposals for the Basel amendment were very similar. Both calculated capital requirements for a trading book based upon a building-block <a href="../articles/var_measure.htm">VaR measure</a>. By 1996, the Basel amendment had evolved. It retained a building-block VaR measure as one option for calculating market risk capital, but it also allowed banks, under certain circumstances, to use their own internal (and presumably more sophisticated) VaR measures. Because CAD did not provide for the use of internal VaR measures, European banks were potentially at a competitive disadvantage compared to banks outside of Europe. To address this issue, Europe rushed passage of an update to CAD, called <b><a name="CAD II">CAD II</a></b>. This was somewhat of a stopgap measure. It allows European banks to base capital requirements on internal VaR measures, but it remains inconsistent with the 1996 Basel amendment in other respects. A new <b><a name="CAD III">CAD III</a></b> will implement the <a href="../articles/basle_committee.htm">Basel II Accord</a>.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table8"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table9"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/barings_debacle.htm">Barings debacle</a> In February 1995, Britain's oldest merchant bank failed due to unauthorized trading by a single individual at its Singapore office.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/basle_committee.htm">Basel Committee</a> A committee of representatives from central banks and regulatory authorities that has played a leading role in standardizing bank regulations across jurisdictions.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/corporation.htm">corporation</a> 1) A group of people, such as a guild or city, with a legal collective identity. 2) A joint-stock, limited liability corporation.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/risk_management.htm">financial risk management</a> Practices by which a firm optimizes the manner in which it takes financial risk.<p align="left" class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/group_of_30_report.htm">Group of 30 Report</a> An influential 1993 industry report on OTC derivatives.</p> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/legal_risk.htm">legal risk</a> Risk from uncertainty due to legal actions or uncertainty in the applicability or interpretation of contracts, laws or regulations.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><strong style="font-weight: 400"><a href="../articles/regulatory_capital.htm">regulatory capital</a> Capital held in accordance with statutory or regulatory requirements.</strong><p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/security.htm">security</a> A financial instrument such as a stock or bond.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/united_states_financial_regulation.htm">United States financial regulation</a> An overview.</td> </tr> </table> </td> </tr> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Sponsored Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" width="75"> <img border="0" src="../images/ad_side_banner_2.jpg" width="103" height="285"></td> <td bgcolor="#FFFFCC" width="99%">  <p class="ad_legend" style="margin-left: 0; 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